6 strategies using member-financed limited recourse loans with … · 2020. 6. 21. · business...

Kris Kitto SMSFs can borrow from banks to purchase investments such as residential and commercial investment properties – but did you also know that a SMSF can borrow from members and other related parties? This eBook contains 6 strategies which demonstrate how SMSF trustees can use related party limited recourse loans to legitimately save tax and boost their returns.

6 Strategies using member-financed limited recourse loans with your SMSF

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Introduction:

Since September 2007 trustees of self managed super funds (SMSFs) have been able to purchase investments such as residential property, commercial property, listed shares and even artwork using gearing via a limited recourse loan provided the underlying asset is held by a custodian trust for the sole and exclusive benefit of the SMSF.

These limited recourse loans can come from the following sources:

1. A bank or financial institution 2. A related party (such as a member of the SMSF, family trust or company) 3. A combination of both

Utilising a loan from a related party of the SMSF instead of, or in addition to, can provide the following advantages when compared to obtaining a limited recourse loan from a bank:

- Reduced upfront costs - Reduced ongoing costs - Flexible repayment terms - Interest is paid to a related party rather than banks with multi-billion dollar profits - Younger SMSF members can inject capital to purchase property without it being trapped

until they retire - High value assets can be transferred to a SMSF without exceeding the contribution caps and

tax deductible contributions can be spread over a number of years - Ability to correctly and legally develop property within a SMSF

How does a member-financed limited recourse loan work?

When a SMSF borrows from a related party, even through the trustees don’t have to go through the rigorous and costly process they do if they where obtaining a loan from a bank lender, the limited recourse loan still must meet all the necessary conditions and restrictions placed on it under Section 67A of the SIS Act.

These conditions can be summarised as follows:

A. The money borrowed must be used for the purchase of a single acquirable asset (including all associated costs) – must also be a new asset – the SMSF cannot already own it.

B. The asset must be held by a custodial trust with the SMSF becoming the sole beneficial owner

C. The SMSF can acquire legal ownership of the asset after making one or more payments on the loan

D. The rights of the (related party) lender are limited to that particular asset only in the case of default – no other SMSF can be touched

E. The asset cannot be subject to any other charge or encumbrance apart from the mortgage registered by the lender (part D above)

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In addition, there are a number of other rules which the SMSF must comply with such as:

- All dealings between the SMSF and its members need to be at arm’s-length (SIS s109) – meaning all interest rates should be at market rates (this applies even with ATO ID 2010/162 which allows lower interest rates to be used) – this means a SMSF cannot borrow from a related party and be forced to pay interest back to that related party at excessively high rates

- The purchase of the asset and the use of gearing in the form of limited recourse borrowing needs to be part of the investment strategy of the SMSF

- The SMSF cannot acquire assets from a related party unless they are business real property at market value or listed securities at market value (SIS s66(2) and s66(2A)). This means residential investment properties typically cannot be purchased from related parties.

- There must be an appropriately documented loan agreement for the limited recourse loan from the related party. This ensures that the money lent to the SMSF will not be considered a contribution.

- The SMSF must still comply with the sole purpose test (SIS s62) meaning any investment or arrangement must be for the core purpose and benefit of the members on their retirement.

Strategies to maximise the benefit of member-financed limited recourse loans:

There are a huge number of strategic opportunities for existing SMSF trustees, their advisers and anyone looking to maximise their superannuation savings that are available with the use of member-financed limited recourse loans.

Below is a series of examples – many of which are based on real life cases that demonstrate some of these great opportunities.

These examples are relatively advanced and in some cases require some assumed knowledge about income tax, capital gains tax and general superannuation and tax planning strategies.


Strategy 1 – 100% member-financed loan (stuff the banks! - kinda)

Simon is a 40 year old home owner with available equity in his principal place of residence of $200,000 and just over $150,000 in an industry super fund.

Simon can roll the monies from his industry super fund into a SMSF and through a separate loan or line of credit draw down the $200,000 which can be leant to his SMSF for the purchase of an investment property valued at around $300,000 – which still leaves an additional amount of cash to cover all related expenses and contingencies.

Diagrammatically this strategy looks like this:

Implications and advantages:

a. Simon significantly reduces his initial and ongoing borrowing costs – no hefty bank establishment or legal fees and the interest on the loan will be the same as what his is paying on his current mortgage – there will be no premium or increased interest rate which he would have been paying if he obtain the limited recourse loan from the bank directly

b. Investment property purchased and will produce income and growth in an extremely tax effective environment

c. The interest the SMSF pays to Simon (taxable income for Simon) will be the same as the interest Simon pays to the bank (tax deductible) – meaning Simon’s personal tax situation will not change

d. Simon can sell the property at anytime and return the $200k to himself e. Simon’s ongoing SGC (9%) and salary sacrifice can be used to gradually pay down the

principal of the loan or these contributions could be built up and used for further investing


Strategy 2 – Best of both worlds – combining bank and related party loans

Melanie and Luke a couple in their mid-thirties and have $110,000 combined in their respective industry and retail super funds.

They are looking at purchasing a $300,000 commercial property; however they are struggling to be able to complete the purchase as with the bank lending them 65% of the purchase price, they don’t have enough to cover the associated loan fees, stamp duty and legal fees while still having a buffer to cover unexpected costs relating to the property.

Melanie and Luke however have personal cash savings of $25,000 which they can use to complete the purchase and give their new SMSF some much needed liquidity. They are reluctant put this money into super as a personal contribution, so they loan it to the SMSF as a second / additional limited recourse loan.



a. The purchase can be completed with extra liquidity to cover unexpected costs. b. The SMSF will pay market rates of interest back to Melanie and Luke on the $25,000 loan c. The SMSF can make lump sum repayments of the $25,000 loan back to Melanie and Luke –

meaning that money is not trapped in their SMSF for at least 25 years until their retirement (which it would be if it was made as a member contribution).

d. The interest received by Melanie and Luke will be taxable income in their names. This strategy could be modified slightly by using a family trust as the lender rather than individuals. This would enable any taxable interest income to be distributed in the most tax effective manner. The larger the amount of the member financed loan, the more important it is to choose the correct structure for the lending entity.

e. No charge or second mortgage can be registered against the title of the property for the loan from the members – only the loan from the bank for their limited recourse loan can do this.


Strategy 3 – Working within the contribution caps

Bill and Sharon are in their earlier forties and are owners of a successful small business which they operate through their family trust.

Until recently they have never put much money into superannuation as all profits from their business have been reinvested back into the business to fund growth and expansion. This strategy has begun to bear fruit and the business has a very strong profit and more importantly very strong cash flow position for the current financial year.

Bill and Sharon have $150,000 in a recently established SMSF and wish to move their business into larger premises to help expansion and increase their capacity to grow their income. They find a suitable property valued at $750,000. They can borrow up to 65% of the purchase price ($487,500) however this means they need about $300,000 in their SMSF to complete the purchase including all stamp duty and other associated costs.

After meeting with their accountant, Bill and Sharon decide to do the following:

- Contribute $25,000 each for the current financial to the SMSF as their concessional (tax deductible contributions)

- Loan the additional $100,000 required to complete the purchase of the property from their family trust to the SMSF as a member financed limited recourse loan



a. The purchase can be completed with extra liquidity to cover unexpected costs. b. Bill and Sharon’s business can pay tax deductible rent to their SMSF for the lease of the

property. c. The family trust can ‘forgive’ part of the loan each year – up to $25,000 x 2 which will act as

Bill and Sharon’s tax deductible super contributions d. As the family trust is a trading entity the loan to the SMSF is an asset of that entity and at

risk – for this reason it should be paid back as soon as possible.


Strategy 4 – Turning a UPE or Div7A loan to your advantage

Todd is a successful small business owner in his late thirties. Todd is not married, has no children and has been operating via a discretionary trust for a number of years. He has $120,000 in a retail super fund.

On the advice of his accountant, to cap the amount of tax he pays at 30% after paying himself a wage from his trust, all excess income has been distributed to a ‘bucket company’ for a number of years. The result of this strategy is that Todd’s trust has a $200,000 unpaid present entitlement (UPE) owing to the bucket company from his trust.

Todd is now in a position where he has the cash available in his trust to pay the UPE in full. Once the cash is in the bank account of the bucket company he can only really pay it out as a franked dividend – however due to his already high personal income, he will still end up paying additional tax on the amounts – which is something he wants to avoid.

Todd is keen on diversifying his income sources away from his current business, so seeks advice from his accountant on the best way to utilise the $200,000 to purchase an investment property. Todd and his accountant decide on the following course of action:

- Establish and rollover Todd’s existing $120,000 retail super to a new SMSF - Todd’s trust to pay out the UPE of $200,000 owing to the bucket company - The bucket company to lend the $200,000 to the SMSF under a limited recourse loan - The SMSF to purchase an investment property either with or without a bank limited

recourse loan in addition to the $200,000 loan from the bucket company



a. The unpaid present entitlement is cleared with the funds utilised to purchase an investment property with no additional tax payable by Todd.

b. The property is held in an extremely tax effective structure with a high level of asset protection.

c. The interest paid by the SMSF back to Todd’s bucket company will be taxable income of the company; however this can be offset via tax deductible concession super contributions on Todd’s behalf.

d. As Todd is a long way from retirement, some or the entire principal of the limited recourse loan from the bucket company can be repaid by the SMSF – which then can be paid to Todd as a fully franked dividend if necessary – although planning would be needed to reduce tax.

Strategy 5 – Property development

You cannot develop property in a SMSF using limited recourse borrowings for two reasons – firstly, it is expressly prohibited under s67A of the SIS Act and secondly the banks simply cannot and will not lend against these transactions. This means that a SMSF cannot purchase a block of land and build a house or units / duplex on that vacant land.

There is a legitimate strategy however that can be used as a work around which is summarised as follows:

- SMSF purchases units in a related non-geared unit trust which meets the requirements of s13.22C of the SIS Regulations meaning the unit trust doesn’t have any borrowings or investments in other entities

- The purchase of the units in the unit trust are legally held by a custodian trust for the sole benefit of the SMSF only

- The purchase of the units are funded by the SMSF with the use of a member-financed (related party) limited recourse loan

- The unit trust will be the legal owner of the land / property and undertake the construction / development



a. The SMSF has beneficial ownership of 100% o the units in the unit trust meaning and capital and income distributions will flow through to the SMSF.

b. The limited recourse loan for the purchase of the units will need to be from a related party as a bank will not lend against such a structure as they can’t obtain any security – the underlying property in the unit trust cannot be used as security.

c. The SMSF or other related parties can purchase additional units to inject further monies if the development / construction goes over budget – but it can’t drawdown any more under the limited recourse loan to fund the purchase – the additional units must either be purchased outright or a second loan and second custodian trust must be established.

d. No need to pay stamp duty on transfer of units in the future compared to using a unit trust with a related party as a unit holder.

e. Additional upfront and ongoing costs for the unit trust.


Strategy 6 – Capitalisation of interest

Brian and Sonia are a couple in their mid-thirties who own their home and have access to about $100,000 of equity which they can use for investment purposes. Brian works full time and his income is $80,000 per year, while Sonia works part time earning $25,000 per year. They have just over $120,000 in their respective industry and retail super funds.

Brian and Sonia are very keen to start building a property portfolio with a focus on cash flow positive investments that also have potential for solid capital growth. Brian and Sonia do the following:

- Set up a SMSF and rollover their existing $120,000 super - Drawdown a separate loan of $70,000 under Brian’s name only and loan it to their new

SMSF under a limited recourse loan that enables any interest to be capitalised - Obtain another limited recourse loan from their bank for $290,000 - Combine their existing super and the two limited recourse loans to purchase a property

worth $450,000



a. If the interest on the $70,000 member-financed limited recourse loan was capitalised at a fixed rate of 8.29% for 10 years, the ending loan balance would be $155,232 which is made up of the original $70,000 plus $85,232 of accrued interest.

b. All the interest paid under the $70,000 loan facility will be tax deductible for Brian – giving tax savings of just over $1,800 per year (assuming a 30% marginal tax rate). This is the case even if the receipt of the income (interest income to Brian from the SMSF) on those same monies is paid in a different year to when the interest expense is incurred / paid.

c. If the property had doubled in value over the same 10 year period and was sold, the total loan of $155,232 could be paid back to Brian. The interest amount of $85,232 would be taxable income – so planning would need to be done to reduce Brain’s other taxable income that year – such as salary sacrificing to the maximum concessional contribution limit or even taking some unpaid leave to spend more time with the family. Any additional tax paid by Brian is somewhat offset by the tax savings from the past 10 years – however this is the costs that must be paid to access these amounts from super before retirement.

d. The SMSF would claim a deduction in the year the capitalised interest was paid back to Brian – saving $85,232 x 15% = $12,785 and significantly reducing the impact of the capital gain on the sale of the property.

e. The interest was not physically paid for 10 years -the SMSF would have built up surplus cash.

Strategy 6 (continued) – Modifications to the strategy

Strategy number 6 shows that the capitalisation of interest on a limited recourse loan to a SMSF for the acquisition of a capital appreciating asset such as property is a powerful strategy.

The strategy simultaneously provides the benefits of an extremely low tax environment (the SMSF) while enabling younger investors who are a long way from retirement to legitimately access a significant amount of the growth of the underlying investment (such as property) and have it returned back to them.

The obvious cost however as shown by this example is the additional taxable income and tax resulting from the lender (in this case Brian) receiving a massive lump of taxable interest income which has accrued and compounded over a number of years.

This creates a very similar dilemma as when an investor personally invests in a negatively geared property – if they have high income, then the tax savings are significant during their period of ownership – which is great, but the capital gains tax bill when they sell can be horrendous and significantly eat into their after-tax return on the investment.

There are a few strategies available to diffuse this tax bomb.

Firstly, if Brain was a little older – say over age 50 when he received the lump of interest on the loan, he would have the ability to make concessional contributions of up to $50,000 per annum, meaning in that financial year he could salary sacrifice the maximum amount, reduce his employment income and reduce the tax payable on receipt of the interest. Cash flow wise he would not be out of pocket as the interest received back from the SMSF would offset the reduction in the amount of his salary received.

Secondly, the lender could be changed. Instead of Brian being the lender for the limited recourse loan to the SMSF, Brian and Sonia could set up a family trust which would obtain the loan (Brian and Sonia’s home as the third party security with Brian and Sonia as guarantors).

Over the years the family trust would claim a tax deduction for the interest payments on the loan (funded by Brian and Sonia) and hence would accrue a large tax loss of just over $58k over the 10 year period. When the loan and capitalised interest is repaid from the SMSF to the family trust, the carried forward tax loss would offset the majority of the $85,232 interest income and leave just over $27k of taxable income to be distributed to the beneficiaries of the trust.

This $27k could be distributed to lower income earners such as Sonia (if she is still working part time), or even any children under the age of 18 who can currently receive $3,333 per annum as a distribution without having to lodge a tax return or even have a tax file number.

Furthermore, the family trust could even make tax deductible super contributions for Brian and Sonia to reduce the distributable income to $0.

In summary it is possible for Brian and Sonia to lend $70,000 to their SMSF, and ten years later recoup their initial capital and any interest paid back into their own name, and only end up paying a maximum of $4,050 in tax ($27k concessional super contributions taxed at 15%) – while simultaneously paying very little tax on a large capital gain enabling further investments in their SMSF.

The key thing to realise with any strategy that utilised member-financed limited recourse loans is that planning is essential. There will always be a trade off between obtaining the short-term year to year tax benefit and the longer-term tax benefit – you just have to decide which one is more important to you and your personal situation.


Summary:

The six examples of how member-financed limited recourse borrowings can be used by SMSF trustees are not an exhaustive list. The idea is merely intended to assist investors and their advisers come up with appropriate strategies and solutions for their situation.

If you as a personal investor are looking to use any savings or built up equity you have to purchase an investment property – either in your own name or in a trust – I strongly suggest you look at the option of utilising your existing superannuation savings via a SMSF with a member-financed limited recourse loan.

The major advantages of this strategy are:

- You may already have the deposit lying unused in your poor performing industry or retail super fund

- Combining your existing super with your personal savings will significantly increase your deposit, simultaneously reducing your borrowing costs and likely making your investment cash flow positive right from the start

- Your age is not an excuse not to use superannuation – as the previous examples demonstrate, using a member-financed limited recourse loan enables you to legitimately have your SMSF repay any capital you inject into the purchase of property – it is not trapped in there until you retire

- 10% capital gains tax – need I say more! - Any additional or extra upfront and ongoing costs are more than offset by the tax savings

and the ability for your superannuation savings to cover these costs - You can save for an investment property deposit using pre-tax income via salary sacrifice –

which will accelerate your wealth creation - You can combine your super with your partner and family members (up to four members in

one SMSF) to share the costs

If you would like to know more about using your super to purchase cash flow positive property, then I recommend that you visit my website: www.evolvemysuper.com.au to read more articles and strategies to help you build your wealth using super.


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Disclaimer:

The views expressed within this document are those of the writer only. The information contained in this book is general in nature and does not take into account your personal circumstances, financial needs or objectives. Before acting on any information, you should consider the appropriateness of it and the relevant product having regard to your objectives, financial situation and needs. In particular, you should seek independent financial advice and read the relevant Product Disclosure Statement or other offer document prior to acquiring a financial product. The author disclaims all and any guarantees, undertakings and warranties, expressed or implied, and shall not be liable for any loss or damage whatsoever (including human or computer error, negligent or otherwise, by one or more of the authorities, or incidental or consequential loss or damage) arising out of or in connection with any use or reliance on the information or advice of this blog. The user must accept sole responsibility associated with the use of the material on this site, irrespective of the purpose for which such use or results are applied. The information on this site applies the law as stated at the time of each post and is no substitute for financial advice. Copyright: The content of this document and related web links are the property of Kris Kitto and is protected under copyright law and international treaty. All rights reserved. Except under the conditions described in the Copyright Act 1968 and subsequent amendments, no part of this website may be reproduced or communicated by any process without prior permission in writing from Kris Kitto.


6 strategies using member-financed limited recourse loans with … · 2020. 6. 21. · business...

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